ABC analysis is done to identify the quality of inventory that a retailer is holding.
It classifies items based on set criteria of sales and profits
Why is it done ?
It helps to understand what is the contribution of various product lines to the profits and which products are blocking the working capital due to slow movement.
Then outcome is to optimize the inventory so as to have the most efficient products in your line
What is A,B and C ?
When carrying out an ABC analysis, inventory items are valued and then ranked. The results are then grouped typically into three bands. These bands are called ABC codes :
A class inventory will typically contain items that account for 80% of total value, or 20% of total items.
B class inventory will have around 15% of total value, or 30% of total items.
C class inventory will account for the remaining 5%, or 50% of total items.
Nomenclature remaining the same the classification parameters may change based on business realities and requirements.
The Pareto Principle
The Pareto principle also known as the 80-20 rule or the law of the vital few states that, for many events, roughly 80% of the effects come from 20% of the causes
It is a common Thumb rule in business.
Ex : 80% of your sales can come from 20% of your products or 20 % of your clients give you 80 % of your business.
20 % of the rich countries contribute more than 80 % of the world’s GDP and 20 % of India’s Population pays 80 % of the Tax collected !
ABC in Category Management
Like many other areas the ABC analysis is widely used in category management too.
Buyers may use sell thru % analysis to arrive at the top 20 articles and then see what percentage of sales or margin they are responsible for.
The sell thru analysis is a factor of denominator or base on which the sell through is determined so if the base is small then it may cause a big variance in terms of contribution to overall sales
It simply means that if we only purchased 100 pieces and 80 of them got sold across 20 stores then this product may not have a significant role to play in overall sales or profitability
Therefore, it is important to look at sell thru % in conjunction with absolute qty sold and its value before taking any decisions
A simple tool that may be used to optimize the inventory is to measure inventory efficiency
Inventory efficiency can be defined as % contribution of a product or a sub cat to sales divided by % contribution to the stock of that category.
Inventory efficiency of 1 suggests that the product in question contributes equally to the sales as well the stock so it may be continued
Similarly an inventory efficiency of 0.5 tells that the product is not doing well and may need to be discontinued or reduced in buying value.
An important observation is that an efficiency of greater than 1 for Ex. Inventory efficiency of 3.5 may suggest widespread stock outs and the fact that the product is not getting replenished as frequently resulting in lost sales
What Actions to take ?
After classifying items into ABC following actions may be initiated :
Increase buying of class A items and increase investment in Inventory of these products
Reduce or eliminate items which are C class items as these products probably do not meet the value expectations or taste of the consumer
Inventory optimization is a continuous process and the items may keep falling in ABC or categories as the market evolves, new competition emerges and the business lifecycle of the retailer attains maturity.